Week 9 Lecture 8 - decision-making

Question 1

What is riskless multiattribute choice?

Answer 1

Select between 2 or more options that differ in 2 or more attributes (e.g., choosing between 3 phones that differ in price, screen size, and battery life).

Question 2

What is intertemporal choice?

Answer 2

one of the attributes that varies is time (e.g., would you rather receive £10 right now, or £25 one year from today?)

Question 3

What are decisions under uncertainty (risky)?

Answer 3

one or more of the possible outcomes are probabilistic (i.e., they are not certain to occur). Sometimes the probabilities are not known precisely, in which case the decision may be referred to as “under uncertainty” or “under ambiguity”

Question 4

Can risk and uncertainty be used interchangeably?

Answer 4

Some authors use “risk” and “uncertainty” interchangeably to mean situations whose outcomes are probabilistic.)

Question 5

What is the expected value?

Answer 5

The expected value (EV) of an option is the sum of each possible outcome weighted by its probability

Question 6

What is the equation for the expected value?

Answer 6

EV = p1a1 + p2a2 + p3a3 + … pnan

a = the value of the outcome
p = the probability of the outcome
n = the total number of outcomes

Question 7

What can risky choices be made from?

Answer 7

1. “from description” –> information about the options is explicitly presented – e.g., in writing
2. “from experience” –> the decision-maker has to learn the outcomes and their probabilities by repeatedly sampling the environment

Question 8

How did a study show that people are risk averse for gains?

Answer 8

Option A: An 80% chance of £4000
Option B: £3000 for sure

Under the expected value:
EV(A) = 0.8 x £4000 + 0.2 x £0 = £3200
EV(B) = 1.0 x £3000 = £3000

80% of people choose option B. This means they are ‘risk averse’ for gains

Question 9

What is expected utility?

Answer 9

Utility can be thought of as the subjective value of an outcome, and is some transformation u(a) of the objective amount.

Question 10

What is the equation for expected utility?

Answer 10

EU = p1u(a1) + p2u(a2) + …pnu(an)

Question 11

Does expected utility have the assumption of rationality?

Answer 11

yes –> they conform to and follow from a set of axioms whose reasonableness it is hard to dispute

Question 12

Under expected utility theory, which option do people choose?

Option A: An 80% chance of £4000
Option B: £3000 for sure

Answer 12

EU(A) = 0.8 x u(4000) + 0.2 x u(0) = 0.8 x 145 = 116
EU(B) = 1.0 x u(3000) = 1.0 x 122 = 122

The preference for B simply requires that the utility of £3000 is more than 80% of the utility of £4000

Question 13

What is a limitation of expected utility?

Answer 13

it is a poor account of reality

Question 14

What is reference dependence?

Answer 14

Outcomes considered as gains or losses with respect to a reference point.
Often the status quo

Question 15

What attitudes do people have for perceived gains and losses?

Answer 15

Risk averse for (perceived) gains
Risk seeking for (perceived) losses

Question 16

What is the endowment effect?

Answer 16

Describes how people tend to value items that they own more highly than they would if they did not belong to them.

Question 17

Give an example of the Allais paradox?

Answer 17

PROBLEM 1
Option A:
- £2500 with probability 0.33
- £2400 with probability 0.66
- £0 with probability 0.01

Option B:
- £2400 with certainty
82% chose B

PROBLEM 2
Option C:
- £2500 with probability 0.33
- £0 with probability 0.67

Option D:
- £2400 with probability 0.34
- £0 with probability 0.66
83 % chose C

Question 18

What is the certainty effect?

Answer 18

• People disproportionately weight outcomes which are guaranteed to occur (or not occur)
  so that:
• “a reduction of the probability of an outcome by a constant factor has more impact when the outcome was initially certain than when it was merely probable”

Question 19

What are non-linear probabilities?

Answer 19

People seem to overweight extreme probabilities and under-weight moderate-to-large ones

Question 20

What is a decision weights function?

Answer 20

a non-linear mapping between stated probabilities and the weight given to the corresponding outcome when forming an overall evaluation of a prospect

Question 21

What can prospect theory be summarised into?

Answer 21

• editing
• reference point
• value function
• decision weights

Question 22

What are 3 problems with prospect theory?

Answer 22

• limited scope
• empirical findings
• purely descriptive

Question 23

How is limited scope a limitation of prospect theory?

Answer 23

There are violations of rationality in risky choice which Prospect Theory doesn’t address

e.g.,
- People’s valuations of two gambles can contradict their choices when asked to pick between them

• The same instability is illustrated by decoy effects. A famous example is the asymmetric dominance effect (aka the attraction effect), a widely-used marketing trick

Question 24

How are empirical problems a limitation of prospect theory?

Answer 24

there are several phenomena in risky choice which contradict Prospect Theory

e.g.,
- peanuts effect can be explained by the value function of Prospect Theory: the subjective difference between (say) $6 and $3 may seem bigger than the difference between $600 and $300, so it seems more worth taking a gamble in the low-stakes case.
- However, the peanuts effect is much smaller (nee, non-existent) when the probabilities are small.
- Prospect theory can’t readily accommodate this.

Question 25

What is the peanut effect?

Answer 25

people don’t mind taking a risk when playing for peanuts

Question 26

Why is prospect theory being purely descriptive a limitation?

Answer 26

• lack of a mechanism
• brings in more questions e.g., where do the curves come from?